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Economics of the EMU

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Fixing the flaws in the Eurozone. What is happening to the Eurozone? Are the troubles of the high-inflation countries (Greece, Ireland, Portugal, and Spain) due to excessive government borrowing that should have been reined in by the Stability and Growth Pact? Is the solution to be found in more stringent enforcement of the excessive deficit procedures? The EU is adopting measures to strengthen the Pact and provide bailouts of governments finding themselves in difficulties. The latest recipient is Ireland – there may be others. De Grauwe (2010) argues that the problem originates not in excessive government borrowing but in excessive private borrowing. When the idea of a European Monetary Unification was initially discussed in the 1970s, a fierce debate broke out between the so-called “Economists” and the “Monetarists” over convergence conditions that should be required prior to monetary unification. The actual functioning of the Eurozone was proclaimed a success on its tenth anniversary in 2009.

Figure 1. Source: EU. Adjustment in the Eurozone: Can reforms help? Since the first debates on the European Economic and Monetary Union decades ago, the major challenge for the countries involved has been to adjust to asymmetric shocks without a flexible nominal exchange rate (Gros 2010). In the early debate it was stressed that the Eurozone scores less well compared with other monetary unions, notably the US, in terms of wage and price flexibility.

This matters. The Optimal Currency Area theory teaches us that in the presence of asymmetric shocks, the slow reaction of wages and prices would not permit the necessary adjustment in competitiveness necessary to bring back actual output to potential. In the first decade of the euro, intra-area adjustment did not pose dramatic challenges as depicted by euro-pessimists at the onset of the common currency. This was to a large extent because in the past the biggest idiosyncratic shocks that hit Eurozone countries were the positive start-up shocks. Our result is in line with expectations. New eBook: Completing the Eurozone rescue: What more needs to be done? Eurozone leaders embraced two bold moves in May – a Greek bailout worth €110 billion, and a Special Purpose Vehicle to fund future bailouts up to €750 billion (counting the IMF’s maximum contribution)--enough to refinance Irish, Portuguese, and Spanish public debt needs for a couple of years.

And the ECB is helping with direct purchases of government bonds. We invited a dozen world-renowned economists to answer the simple question: What more needs to be done? The eBook posted today – “Completing the Eurozone rescue: What more needs to be done?” – presents their answers. Although the essays were largely uncoordinated – and the authors hark from diverse backgrounds – a remarkably coherent message emerges. The authors unanimously believe that the crisis is not over, and that the Eurozone rescue is not finished. As Charles Wyplosz puts it, the Eurozone is levitating on the hope that European leaders will find a way to end the crisis and take steps to avoid future ones.

Reforming the Stability Pact: Focus on financial supervision. The current European economic governance needs reform. This column argues that rather than trying to invade national governments’ autonomy in economic policy, the European authorities should focus on the transfer of sovereignty in the field of financial supervision. The economic governance of the Eurozone is under repair. After months of work and deep thinking involving several institutions, including the ECB and the governments of France and Germany, the Commission has proposed a reform plan. The reform is aimed at the two problems that the financial crisis of Greece highlighted: First, the Stability Pact and the European surveillance mechanisms have failed.

Indeed, they could not counter the accumulation of imbalances in the public finances and foreign accounts of southern European countries. Second, the mistakes of some countries threaten the resilience of the whole system. Any response to these issues must involve a transfer of sovereignty from the national to the European level. Eurozone reform: Not yet fiscal discipline, but a good start. After months of negotiations at all levels, including the Van Rompuy task force and sharp statements by the German government, the Commission has put forward its proposal to reform the Stability and Growth Pact. The ball is now in the court of the Council of Finance Ministers who, in all likelihood, will give their blessings to the proposal, at least to its core. The Commission, at long last, admits that there was something wrong with the pact, including after the 2005 revision that it had previously described as nearing perfection.

The Greek debt debacle, and its contagious impact on several other countries, had made this position untenable. The creation in May of the European Fiscal Stability Fund, endowed with a mega-borrowing ability of €440 billion, was hard to swallow in some countries. Any reform should start with a diagnosis of what was wrong. The first one, which we could call the German view, is that the pact is too weak. These two views are largely mutually exclusive.

Why a tougher Stability and Growth Pact is a bad idea. The European Commission has presented its proposals to strengthen the Stability and Growth Pact (SGP). If accepted by the Council, this will be the third version since the start of the Eurozone. The first version was a relatively tight set of rules that included sanctions for those countries that failed to bring back their budget deficits below 3%. It ran into difficulties when the German and French governments refused to abide by the rules in 2003. This led to SGP-II in 2005 that was a much-diluted version of SGP-I in that more exceptions to the fiscal rules were allowed. Under pressure from Germany, the European Commission now proposes SGP-III; a considerably tighter version of SGP-I. There are two innovations in SGP-III. First, the financial penalties are extended to countries failing to bring back their government debt levels below 60%.

I want to argue that SGP-III is a very bad idea. Spending and taxation in the Eurozone are still an overwhelmingly national affair. Figure 1.